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Loving those muni bonds but don’t overlook their risks

Municipal bonds have always been a hit with those in the appropriate tax brackets. And with the current changes in taxes, munis are set to become more popular than ever. Even so, make sure not to let their tax-free appeal cloud their investment risks.

Any kind of a tax exemption, whether it’s from the federal, local or state level, is enough to get an investor’s attention. With municipal bonds, the outcome of the fiscal cliff on our taxes has only sweetened the tas-free pot.

Last year, tax-exempt bonds earned about 330 basis points more that Treasuries, according to Hamlet Capital in a piece written for SeekingAlpha.com. And in November, investors began pouring into muni-bond funds in fear of what the fiscal cliff could mean to individual tax brackets. From Nov. 7 to Nov. 12, for example, about $500 million of new money flowed into muni bond funds, according to Lipper U.S. Fund Flows.

While municipal bond issuance in 2013 is expected to exceed 2012 levels, there are common risks to munis every investor needs to be reminded of. But before going there, a word about this year’s expected bond issuance.

According to a 2013 SIFMA Municipal Issuance Survey, both short- and long-term issuance is expected to reach $458.0 billion this year. That’s up from $420.3 billion in 2012.

As for the risks, in reality the default rate of muni bonds has remained very low in recent years— typically around 1 percent. Downgrades also can happen. Lower rated bonds are often the ones most likely to experience problems although I do remember the AAA-rated WPPSS bonds that defaulted in the early 1980s. Oh my.

There also is talk that Congress, in an attempt to get more tax revenue, will impose a limit to the amount of tax exemption on municipal bond interest income one may receive. Estimates put that limit at 28 percent. I hoping that won’t happen. Gobble up all of the tax-free income that’s appropriate for you is what I say no matter what the climate in D.C. appears to be.

Last month the SEC issued an Investor Bulletin titled “Municipal Bonds: Understanding Credit Risk” to help investors better understands some of the risks of these tax-free vehicles.

In that Bulletin is information about things like the differences between general obligation bonds and revenue bonds. As well as the importance of understanding that some revenue bonds are non-recourse bonds—-meaning that if their revenue stream dries up so does yours and investors will have no recourse should that happen. Plus, info about why learning about the purpose for the bond issuances is so important as is its credit rating.